Network Economics and the Information Economy Howard Davies

Is it a New World? n Macro-economic laws suspended –growth, high output, high employment without inflation n Dot.com firms with no profits had high valuations n BUT Shapiro and Varian (1999) –Technology changes, Economic laws do not

The Information Sector has some unusual features n On the revenue side - network effects n On the cost side - sunk costs, high fixed cost very low marginal cost n Overall - “increasing returns” which might threaten the effective working of the market economy - MAYBE

The Information Sector has some unusual features n Not usually covered in elementary texts n Require some new analytical tools n Analysis not really ‘settled down’ yet –Shapiro and Varian –Liebowitz and Margolis –Economides

Networks n “Nodes” and “links” –in computing, in marketing, in sociology, in economics (firms or people and cables or radio signals n Network effects –the value of a network product increases as more are connected to it, or use it

Network Effects may lead to Externalities n Externality - a cost or a benefit which is not taken into account by the decision-maker –pollution - a negative externality –vaccination - a positive externality –the benefit others get when I join a network or use a standard product - a positive externality n Externalities lead to ‘market failure’ but the problem may be resolved by ‘internalising’ the externality - perhaps through ownership

See the Liebowitz and Margolis analysis n Book Chapter p.400

A Demand Curve for a Network Can Be Derived n See p.402 n Under perfect competition the network is ‘too small’ n Under monopoly, smaller and more expensive n Under Cournot competition, with one standard, varies between the two above

Choice of Standards n See p for the ideas of: –autarky value –synchronisation value –total value –supply price –net value –the ‘tipping point’ - X

Choice of Standards n Note that if different consumers have different X’s multiple standards may be an equilibrium n Multiple standards will also arise if the supply price slope is greater than the synchronisation value i.e downward sloping net value curve

Choice of Standards n Can an inferior standard dominate? n If one standard is STRICTLY SUPERIOR preferred to another at all divisions of the market, the superior will prevail n If one standard is WEAKLY superior i.e. A is preferred to B when both have z% market share, A will dominate

Choice of Standards n An inferior standard might dominate in the following situation; –A is weakly preferred to B by all customers, whose switch points are between 10% and 30% (some will prefer A if it has only 10% share, some don’t prefer A until it has 30% share) –if A has less than 10% everyone prefers B n see the diagram on p.405 –if the better standard enters first, it dominates. The owner of the inferior standard can only take over if 87.5% of customers can be shifted –if the inferior standard arrives first, it dominates, but the owner of the superior standard only has to persuade 12.5% of customers to shift

Other Results on Standards n What decides whether a firm adopts a standard when a number are available? –Size of extra benefit to customers from the firm joining - affects ‘new member’ and existing members in same direction –The size of the ‘coalition’ being joined - numbers already using the standard –The increase in competition within the coalition –THE LAST TWO WORK IN OPPOSITE DIRECTIONS AND DEFINE AN EQUILIBRIUM –Also the cost of compatibility relative to extra profits earned –If cost of compatibility is less than extra profit 100% compatibility will be achieved, but not otherwise

A Monopolist Invites and Helps Entrants? n Intel licensed its technology to AMD, creating a competitor - WHY? n Because Intel’s sales depend on customers expectations of ‘how many people will buy this?’ n People know that monopolists restrict output so licensing someone else increases the volume of sales

The Cost Side n High fixed costs, which are also sunk costs –‘first copy’ costs –promotion costs n Very low marginal costs n Easy ‘scalability’ - no natural limits to output

Consequences of This Cost Structure? n With identical products, price is forced down to MC - Bertrand competition n No viable ‘business model’ without price discrimination or product differentiation n Price discrimination: –personalised pricing - first degree p.d e.g.Lexi Nexis –third degree - different prices by group

‘Versioning’ n Delay n Complexity and Power of the Interface n Convenience n Image Resolution n Speed n Flexibility n Features n Annoyance n Technical Support

How Many Versions? n How many identifiable markets? n The ‘Goldilocks’ approach –consumer psychology -‘framing’ choices affects the choices made -prospect theory –with a cheap/medium choice buyers chose cheap –with a cheap/medium/expensive choice most chose medium n Bundling - Microsoft Office

Lock-In n Switching costs create lock-in –CDs to minidisk –printers which work with only one type of PC –training to use a new approach –changing mobile phone numbers (if no portability of numbers) n Lock-In creates profits because price can be raised above MC

How Can I Create Lock-In? n contracts n durability n specific training n formatting information n be the sole supplier with the capability n search costs n loyalty programmes - air miles

Increasing Returns: The Biggest Issue of All n Market economies fail, just as we reach the ‘End of History’ n Scale Economies are the Simplest Example n Network effects and Lock-In mean that History Matters and there is Path Dependence n Markets may ‘Lock-In’ inferior products n Firms Acquire Monopoly Positions and the market fails n IS THIS TRUE?

Arthur and David’s Argument

But Is It True? n If there is a superior standard it will pay the owner to induce the first sales –lease it with cancellation option –get a ‘high profile’ early adopter to influence others –bribe early adopters –advertise –give distributors incentives

Example 1: The QWERTY Keyboard n QWERTY was designed to be inefficient in the 1890s n Because of the network effects and lock-in we still use it n There are better keyboards, e.g. Dvorak n BUT THIS IS A MYTH!

Example 2: Word/Excel/Money n Wordprocessing was dominated by Wordperfect n Spreadsheets dominated by Lotus and then QuattroPro n Both failed to adjust to GUI/Windows and to integrate: Office is a better product! n Microsoft Money does not dominate so ownership of Windows does not give guaranteed leverage

Some Sceptical Questions About the Basics n The value of a network or a standard increases as more participants join –but does it always? Standard economic logic predicts decreasing returns - the most valuable links come first successive links are less valuable n Marginal cost is almost zero and ‘scalability’ is huge –but what if complementary products needed?

Is It Really So Different? n When we eventually get the analysis right will we find that the network economy and information products are really just like everything else?